Demystifying Options Contract: What You Need to Know?

Key Highlights:

• An options contract is an agreement through which you can buy or sell an underlying asset at a fixed price later
• Call option and put option are two types of options contracts
• Options contracts help you in risk management

____________________________________________

Stock markets provide a wealth of opportunity for investors of all kinds. While every investor has different risk tolerance and financial goals, they all agree on one common investing aspect – risk management. Options contracts are widely used in stock markets and can be a powerful tool for risk management. Thanks to their ability to hedge against potential losses, options contract arm investors and traders with the flexibility to protect their portfolios against adverse market movements and capitalise on opportunities presented by markets.

What is an options contract?

An options contract has two parties - a buyer and a seller. In simple terms, it's a deal between both parties whereby they decide to buy or sell an underlying asset or stock at a fixed price in the future. To better understand an option contract, you need to be aware of certain terminologies:

• Strike price

It's the price at which the option's holder can buy or sell the underlying asset.

• Premium

It's the price you pay to purchase the option, and it is paid upfront.

• Expiration date

It's the date at which the option expires. Post this date, the option is useless if it is not exercised.

• Underlying asset

It's the asset on which the option contract is based. This asset could be anything, including bonds, commodities, indices, etc.

Types of contracts

Now that you know the meaning of options contracts, let’s see their types:

• Call option

The call option gives you the authority to buy an underlying asset at the strike price within the set time. Generally, this option is exercised when there's a feeling that the underlying asset's price will go up.

• Put option

With the put option, you can sell an asset at the strike price within a certain timeframe. This option is exercised when the asset's price is expected to fall.

Benefits of options contract

Options contracts offer the following benefits:

• Helps in risk management

Risk management is essential in stock markets. Option contracts help you manage your risk prudently. You can protect your portfolio against adverse movement in prices through them. For instance, by exercising the put option, you can protect against a decline in the value of stocks.

• Take advantage of short-term price movement

Option contracts help you take advantage of short-term price movements. For example, you can benefit from an increase in prices through the call option. Also, they allow you to take a position based on your needs and risk tolerance.

In conclusion

When used wisely, options contracts can be a powerful tool for mitigating risks and generating profits. However, to fully utilise their potential, it's vital to have a comprehensive understanding of your risk tolerance and financial goals and, more importantly, to educate yourself on their working mechanism.

FAQs

How do I use options contracts?

In your demat and trading account, select options to buy or sell. Predict the strike price and determine the option time frame.

Why use options contracts?

You can use options contracts to hedge against price volatility and benefit from short-term price movement.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here. 

Investments in securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI prescribed Combined Risk Disclosure Document prior to investing. Brokerage will not exceed SEBI prescribed limit.